Using Exchange-Traded Volatility Notes? Be Prepared to Spend Money, Be Wrong

By

Brendan Conway

Oct. 11, 2013 11:43 a.m. ET

Order Reprints

Print Article

Text size

Buying an exchange-traded fund or note to profit from a stock-market decline, or big swings in the market? Hold on a second. There's a lot more going on in these trading vehicles than "profit from volatility."

Volatility ETFs and ETNs are complex enough, and designed to behave with sufficient similarity to an options contract, that you might be better off going straight for options. Or, better yet, if you're worried about the stock market, just move to cash. At least in that case, you know your money will be there in a few weeks, which often isn't true of cash devoted to volatility exchange-traded funds.

Investors who are new to the ETFs/ETNs got a taste of it on Thursday. iPath S&P 500 VIX Short-Term Futures ETN (VXX) slumped 13% as stocks soared, including the biggest single-day jump in the Dow since December 2011. The leveraged version, ProShares Ultra VIX Short-Term Futures ETF (UVXY) slumped a remarkable 21%. They're both down again on Friday by anywhere from 2% to 5%. For 2013, they're down 50%-80%.

Getty Images

Losses are routine in these products. Once you get past the complex mechanics you'll see it happens for reasons similar to why a put option's price decays over time.

These trading vehicles don't even reflect "volatility" as the average investor might understand it. They instead track continuously rebalanced baskets of futures contracts on the CBOE Volatility Index.

Most of the time, their price moves will reflect what's called a "negative roll yield," as the funds/notes sell some (usually less expensive) short-dated futures and buy some (usually more expensive) longer-dated ones. It's the opposite of "buy low, sell high." Think of it as a kind of cost of insurance that you're paying all the time. As the YTD performance slump shows, those costs add up.

It turns out investors have put about as much cash -- $1.3 billion -- into the two just-mentioned trading vehicles as they currently hold altogether, even though each entered 2013 already containing a pool of investor assets. VXX's net inflow the last three years is $2.8 billion. The ETN's three-year annualized loss of 61% gives an idea where the money went. Figures are from XTF.com.

When there's a disaster in the market, the value of those near-term futures may skyrocket, which I guess is why investors keep pushing money into these ETFs and ETNs.

But just as quickly the air can come out of the market's volatility premium. Which is what happened yesterday. Bloomberg News' Nikolaj Gammeltoft, Nick Taborek and Aubrey Pringle round up a few market veterans who caution against getting in too deep:

"People perceive the VIX as being an appropriate hedge, but as the price action shows over these last couple of days, its moves can be pretty quick and ugly," Eric Augustyn, the Charlotte, North Carolina-based head of options strategy for Wells Fargo Private Bank, which manages $170 billion, said via phone yesterday. "It moves too quickly." ....

"It can be devastating if you judge it wrong," Jack Ablin, chief investment officer for BMO Private Bank, said in a phone interview from Chicago. He helps oversee $66 billion.

"You not only have to get the pricing right, you have to get the timing right and the penalties for being wrong are so high that it just seems hardly worth it." ...

"The VIX is going to be whipped around by headlines," Frank Ingarra, head trader at Greenwich, Connecticut-based NorthCoast Asset Management LLC, said by phone yesterday. "Who knows how people are going to react to what different congressmen or the president or whoever says. You probably have actually better odds in Vegas than you do playing the VIX."

Bloomberg also found somebody to defend their use:

[U]sing VIX notes is a sensible strategy to protect against stock declines, according to Chris Blum, global head of equities for JPMorgan Private Bank. Investors are using VIX notes more than ever because it's easier for investors to buy and sell the securities, compared with other derivatives, and the volume of trading means traders can quickly enter and exit positions.

"If you think volatility is cheap, you may buy it as portfolio insurance, a way in which to guard against potential losses," Blum said in a phone interview yesterday. "It's like many types of insurance policies, like life insurance or otherwise, you hope you don't have to collect on it."

Friday, VelocityShares Daily 2X VIX Short-Term ETN (TVIX), another leveraged VIX futures ETN, is down 6%, while VelocityShares Daily Inverse VIX Short Term ETN (XIV) and ProShares Short VIX Short-Term Futures ETF (SVXY), the unleveraged opposites of the above-named funds/notes, are ahead by a little more than 3%.

This copy is for your personal, non-commercial use only. Distribution and use of this material are governed by our Subscriber Agreement and by copyright law. For non-personal use or to order multiple copies, please contact Dow Jones Reprints at 1-800-843-0008 or visit www.djreprints.com.